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The Most Important Bank in The U.S. -- And Maybe the Entire World

On this episode we take a look at the history and purpose of the Federal Reserve.

With financial crises deposited in our history nearly every decade until the early 1900s, the Federal Reserve was founded to reduce the chances of recession's reoccurrence.

As interest rates remain low, many fear that they are never more than a small percentage from causing another depression. And with inflation and unemployment skirting their safety lines, there's no question that financial analysts are constantly watching with risk at the forefront of their minds.

Find out how the Federal Reserve is fairing, on today's edition of Industry Focus.

A full transcript follows the video.

Kristine Harjes: The biggest and most important bank in the United States, and maybe even the world. This is Industry Focus.

[INTRO]

Hi, folks. Kristine Harjes here for The Motley Fool, and today I'll be digging into the Federal Reserve bank. Its history and purpose, some issues that it's facing today, and I've got with me our Foolish senior banking analyst, John Maxfield. So, the U.S. Federal Reserve, the central bank of the country actually just had its centennial two years ago.

Let's start there; at the very beginning. John, can you tell us a little bit about why the fed was created?

John Maxfield: Yeah. Absolutely. So, if you go back, the Federal Reserve came into being in 1913 and that was six years after the panic of 1907, and those two things are not coincidental. If you go back to the beginning of banking in America, or the beginning of 'modern' banking in America -- which was the civil war when Abraham Lincoln pushed through the national banking acts in order to fund the civil war -- he put into place a national currency, he allowed for the establishment of national as opposed to state banks.

So, if you go from the civil war until the panic of 1907, in almost every single decade we had a major banking panic, and frequently these turned into full-fledged economic depressions that were akin to the economic depression of the 1930s. So, the thought was, policy makers and bankers of the United States looked around the world and said "Why is it that the United States is so prone to these economic disturbances, while other places are not prone to them on the same frequency?"

They concluded that it was likely because we didn't have a federal reserve. What the Federal Reserve does is, it acts as a lender of last resort. So, when you go through a banking panic -- because banking panics are natural. When you have credit, credit makes countries grow, but then sometimes people get a little bit out of control with their credit. We saw this during the housing bubble right before the financial crisis.

When that gets out of control you need an entity that can step in and help the banking system from totally freezing. That's what that lender of last resort function is at the Federal Reserve. That's why they put it into place; to hopefully decrease the incidents of financial panics.

Harjes: So, that lender of last resort thing; that's clearly a huge part of the fed's purpose. Can we hit on any other angles that the fed also has to consider in their job other than just this 'in a crisis, lender of last resort' function?

Maxfield: Absolutely. The 'lender of last resort' function was really the impetus -- as I understand it -- for the Federal Reserve in the first place. But once that impetus was there they built in a variety of other responsibilities. One of which it has become a primary regulator in the banking space. More specifically it is the primary regulator -- not of the banks themselves, but of the bank holding companies that then own the banks.

So, that's their primary regulatory role. Beyond that -- and this is something that a lot of listeners would have probably heard about -- you have the dual mandate. That is where the Federal Reserve is responsible for balancing low inflation, a relatively stable money supply against full employment. Which, full employment is something like 5% to 6% or 6.5% unemployment.

If your unemployment goes too low, there's too much money going around in the economy, and inflation will go up, and vice versa. If inflation goes down and -- particularly if you have deflation you have unemployment go up. So, that dual mandate is all about balancing those two things.

Harjes: So, are they contradictory goals, or what?

Maxfield: Well, theoretically, in economics it's not that they are contradictory, but they go in different directions. As inflation goes up, theoretically unemployment goes down, and vice versa. So, it's about keeping those in a stable equilibrium that makes the economy -- that facilitates economic growth, but at the same time, not letting it get totally out of control.

Harjes: This is probably more of a question of opinion, but do you think that traditionally the fed has leaned heavier toward one as opposed to the other?

Maxfield: Wow. That's a great question. If you look back in time the Federal Reserve is -- we've had really dramatic inflation of periods in history. We had some oil embargos in the 1970s that caused consumer prices to go through the roof. The Federal Reserve then stepped in and played a very robust role under Paul Volker, of bringing inflation down. Then that kicked it into a pretty severe recession, which jacked unemployment up.

So, one could say at that point they were certainly favoring price stability over unemployment, but I would say that nowadays they're favoring reduction of unemployment over price stability because interest rates are still super, super low even though we're finally starting to see economic activity pick back up. But they're still not interested -- at least they haven't increased interest rates yet -- which would lead me to believe that right now, they're really interested in getting that unemployment to stay really low, and to get industrial activity picking up.

Harjes: So, talk to me a little about how interest rates are tied into the dual mandate.

Maxfield: Interest rates are tied into the dual mandate through the banking system. So, let's say the Federal Reserve wants to control inflation. What you do is, you would increase interest rates which makes lending less profitable for banks. When I say 'increase the interest rates', you'd increase short term interest rates, and because banks make money by arbitraging between shot term and long term interest rates, if you increase short term interest rates that's going to decrease their profit margins.

So, that's going to make lending -- and therefore the availability of credit -- a less, to put it in F.D.R.'s terms "fashionable trend" nowadays -- or when that's going on. Then on the other side, as you decrease interest rates you make the provision of credit more profitable. So, that will then boost credit, which by boosting credit will then boost economic activity. So, everything goes through those interest rates in terms of achieving a dual mandate.

Harjes: Interesting. So, we've got that dual mandate; inflation, unemployment. Isn't there a conversation that's been going on about another benchmark that is a little bit more unprecedented that might be used?

Maxfield: That's exactly right. And this is a really interesting thing going on with the Federal Reserve right now. If you go back to the great depression one of the things that people blame the Federal Reserve for is not only getting us into the great -- turning a normal recession into a great depression by imprudent monetary policy -- but then after on in the 1930s and 1937 in particular, the Federal Reserve saw industrial activity slightly picking up. They saw inflation slightly picking up, and they wanted to nip that in the bud because this was only a decade and a half after that extreme inflation in Germany triggered the ascent of Hitler and all those horrible things that then came afterward.

So, the Federal Reserve in 1937 jacked up interest rates, and that then pushed the U.S. economy back into the great depression. So, the fear right now is if they increase interest rates it's going to do the same. So, what they're doing is, not only are they watching unemployment and inflation, but they're also watching economic growth and industrial activity. The thought process is that if they can get industrial activity on a stable path, it's at that point that they can feel comfortable raising interest rates.

Harjes: How can you measure industrial activity?

Maxfield: Oh, they have 100s of statistics that do that. On a very, very high level you have your GDP, your GMP figures, but then you can go down into specific industries. You can look at steel production, you can look at car production, you can look at all those different things; but it's really -- what I mean by 'industrial activity' is the activity in the actual economy, not in the money markets that banks are overseeing.

Harjes: Interesting. So, I can see why they would have to be careful given all that history. Along that same line, what are some of the criticisms of the fed?

Maxfield: If you go back to the very beginning, one of the main criticisms is that it was created to be a cartel that protected the large, national money center banks at the expense of small banks. Because before that, anybody could open a bank and then be given the opportunity to succeed. But once the Federal Reserve stepped in it was much more difficult. There were much larger barriers to entry into the industry.

So, that's one of the biggest criticism that the Federal Reserve -- in terms of its inception. But then more recently, the thought is that the Federal Reserve is biased toward inflation. As inflation increases, that decreases what the money that is in everybody's savings account -- it decreases what that's worth. So, for people who are retirees, who are not in the market right now making money -- who no longer work -- that's a big problem.

Then when you have low interest rates like this, obviously, people who are on fixed income in retirement -- or for whatever other reason -- they see their income on an annual basis decrease. So, that's another big problem that people identify with the Federal Reserve. I don't want to say 'problem', but I would say criticism.

Harjes: Okay. Sure. So, what do you think is next? There's a lot of talk about interest rates and how they're going to need to be raised eventually. Is that what you think the fed is going to do as its next big play, or do you think they'll just sit tight for a little bit? What's coming down the pipe?

Maxfield: Well, the big question is whether or not the United States is going to repeat a pattern that we're seeing in japan right now with relatively stable economic activity. You're just not seeing much growth and you're seeing that because of that -- so, japan, if you go back to the mid-1990s, it had a very similar crises to what we experienced in 2007, 2008, 2009, and it has not been able to get economic growth back up and going again.

Because of that, their interest rates over there have stayed lowed for this entire time. So, almost 20 years. So, the concern is that if the United States can't get things up and going again, that interest rates are just going to stay low, presumably, indefinitely. But the more optimistic view is that things will recover, things will get back up and going, our demographics in this country are much more positive than Japans.

We have much more natural resources than Japan has, we have a much larger industrial base than Japan has. So, when you factor all those things in the people who are optimistic about things say that Japan comparison probably isn't fair. But it is certainly one extreme that could come about if things don't start picking up. If they do start picking up then we'll see interest rates start to pick up as well.

Harjes: And so, for now, we hang tight and we watch. Alright.

Maxfield: Yep.

Harjes: That's all the time we have for today. John, thank you so much, as always. Folks listening at home, and remember that we've got an email address setup just for you guys if you want to reach out to us with any questions, or topics that you'd like us to cover on the show. The email address is industryfocus@fool.com. I know I speak for both John and myself in saying that we would love to hear from you. Until next time, Fool on!

As always people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against. So, don't buy or sell stocks based solely on what you hear.